1957 (Hospitality) (HKG: 8495) seems to use debt quite wisely
Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” It is only natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a business collapses. Above all, 1957 & Co. (Hospitality) Limited (HKG: 8495) carries a debt. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first step in examining a business’s debt levels is to consider its cash flow and debt together.
Check out our latest analysis for 1957 (Hospitality)
What is the 1957 debt (hospitality)?
As you can see below, at the end of June 2021, 1957 (Hospitality) had a debt of HK $ 101.8million, up from HK $ 20.2million a year ago. Click on the image for more details. On the other hand, he has HK $ 79.5million in cash, resulting in net debt of around HK $ 22.3million.
How strong is the 1957 balance sheet (hotels)?
According to the last published balance sheet, 1957 (Hospitality) had liabilities of HK $ 113.9 million due within 12 months and liabilities of HK $ 31.3 million due beyond 12 months. On the other hand, he had HK $ 79.5 million in cash and HK $ 8.46 million in receivables due within a year. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by HK $ 57.2 million.
While that might sound like a lot, it’s not that bad since 1957 (Hospitality) has a market cap of HK $ 115.2million, and so could possibly strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While the low 1957 debt-to-EBITDA (Hospitality) ratio of 0.61 suggests modest use of debt, the fact that EBIT only covered interest expense 3.7 times last year gives us pause for thought. . But the interest payments are certainly enough to make us think about how affordable his debt is. We also note that 1957 (Hospitality) improved its EBIT from a loss of last year to a positive amount of HK $ 12 million. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since 1957 (Hospitality) will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) is supported by free cash flow. Fortunately for all shareholders, 1957 (Hospitality) actually produced more free cash flow than EBIT over the past year. There is nothing better than cash flow to stay in the good favor of your lenders.
Our point of view
From our analysis, converting EBIT to 1957 Free Cash Flow (Hospitality) should indicate that it will not have too many problems with its debt. However, our other observations were not so encouraging. For example, it looks like he has to struggle a bit to cover his interest costs with his EBIT. Given this range of data points, we believe 1957 (Hospitality) is well positioned to manage its debt levels. But beware: we believe debt levels are high enough to warrant continued monitoring. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 3 warning signs with 1957 (hospitality), and understanding them should be part of your investment process.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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